How does inheritance tax (IHT) work?

When you die, your executors will assess how much your estate is worth by adding up your assets, and deducting the value of any debts. Your estate will then normally pay tax at 40% on anything above the IHT nil-rate band, currently £325,000, and not due to increase until 2021. Married couples and civil partners can pass their nil-rate band to the surviving spouse meaning that, jointly, there will normally be no IHT to pay on the first £650,000.

How is this changing?

A new family home allowance (known as the main residence nil-rate band) is being introduced in stages from next April, and is set to eventually provide an extra £350,000 worth of IHT-free allowance for a married couple or civil partners.

From 6 April 2017, an additional allowance of £100,000 per person will be introduced for individuals where a property that has been their principal residence (or a property that has been used as a main residence in the past) is passed to a direct descendant. This will effectively take the threshold at which IHT becomes payable to £850,000 for family beneficiaries.

The threshold will then increase to £125,000 in the 2018/19 tax year, £150,000 in 2019/20 and £175,000 in 2020/21.  Estates worth £1m that include a qualifying property worth at least £350,000 could at this point be passed on tax-free.

For larger estates, there is an exception. Where the value exceeds £2m, the additional residence nil-rate band will be tapered at a rate of £1 for every £2 over this amount. This means it would be completely lost if a joint estate is worth more than £2.4m in 2017/18, rising to £2.7m from 2020/21. Proper estate planning therefore continues to be vital for many wealthier families.

In what circumstances will the new allowance not apply?

The additional allowance will only apply to a single main residence – investment or holiday properties won’t count. However, it will be available to those who downsize or sell their home (or have done so since 8 July 2015) and, on death, pass on assets of an equivalent value. However, if this is the case you will need to keep details of the sale of the property and evidence it was your main home.

In addition, the residence nil-rate band will only apply to properties left to direct descendants – defined as children, grandchildren and step, adopted or foster children and their lineal descendants.

Ways to reduce inheritance tax

If your estate is likely to be larger than the available allowances, there are ways to mitigate tax including making gifts, investing in assets such as IHT-free assets such as Alternative Investment Market (AIM) shares and using trusts. Pensions are generally outside a person’s estate for IHT purposes and provide a further potential mechanism for wealth to pass through generations of a family tax-efficiently.

The rules regarding IHT and gifting are complicated, and for those who are unsure or have complex financial affairs, we would always suggest seeking advice from an expert.

Rob Morgan is a pension and investment analyst at Charles Stanley Direct